Brief Contents Parti Part IV Financial Markets and Financial Instruments 1 Raising Capital 2 2 Debi Financing 29 3° Equity Financing 76 Pan It Valuing Financial Assets 4) The Mathematics and Statistics of Portfolios 105 5 Mean-Variance Analysis and the Capital ‘Asset Pricing Model 142 6 Factor Models and the Ar Theory 193 7 Pricing Derivatives 234 8 Options 274 Part lt Valuing Real Assets 9 Investing in Riskless Projects 318 10 Investing in Risky Projects 360 11 Allocating Capital and Corporate Strategy 408 12 Corporate Taxes and the Impact of Financing ‘on Real Asset Valuation 445 Capital Structure 13 How Taxes Affect Financing Choices 488 14 How Taxes Affect Dividends and Share Repurchases 517 15 Bankruptcy Costs and Debt Holder-Equity Holder Conflicts $42 16 Capital Structure and Corporate Strategy 577 s, Information, and Corporate Control 17 How Managerial Incentives Affect Financial Decisions 605 18 The Information Conveyed by Financial Decisions 632 19 Mergers and Acquisitions 666 Par VI Risk Management 20. Risk Management and Corporate Strategy 711 21 The Practice of Hedging 743 22 Interest Rate Risk Management 787 Appendix A Interest Rate Mathematics $24 Appendix B Mathematical Tables 837 xvContents Part] nancial Markets and Financial Instruments 1 Raising Capital: The Process and the Players 2 1.1 Financing the Firm 3 Decisions Facing the Firm 3 How Big Is the U.S, Capital Market? 5 1.2. Public and Private Sources of Capital 6 1.3. The Environment for Raising Capital in the United States 8 ‘The Legal Environment 8 Investment Banks 10 The Underwriting Process 11 The Underwriting Agreement 12 Classifying Offerings 12 The Costs of Debt and Equity Issues 15 Types of Underwriting Arrangements 15 1.4 Raising Capital in International Markets 18 Euromarkets 18 Direct Issuance 18 1.5 Major Financial Markets Outside the United States 18 Germany 18 Japan 20 United Kingdom 21 xvi 1.6 Trends in Raising Capital 24 Globalization 24 Deregulation 24 Innovative Instruments 24 Technology 25 Securitization 25 1.7 Summary and Conclusions 25 Debt Financing 29 2.1 Bank Loans 30 Types of Bank Loans 31 Floating Rates 32 Loan Covenants 33 22° Leases 34 2.3 Commercial Paper 35 Who Sells Commercial Paper? 35 Buyback Provisions 35 24 Corporate Bonds 35 Bond Covenants 35 Bond Options 41 Cash Flow Pattern 44 Bond Prices: Par, Discount, and Premium Bonds 49 Maturity 49 Bond Ratings 50 ‘The High-Yield Debt Market 50 2.5 More Exotie Securities 53 ‘Tax and Regulatory Frictions as Motivators for Innovation 53 Collatcralization as a Force for Innovation 54 Financial Innovation in Emerging26 27 29 2.10 Contents ‘The Junk Bond Market and 3 Financial Innovation 54 A Perspective on the Pace of Financial Innovation 55 Raising Debt Capital in the Evromarkets 55 Features of Eurobonds 55 Size and Growth of the Eurobond Market and the Forces behind the Growth 56 Enrocurrency Loans 56 Primary and Secondary Markets for Debt 57 The Primary and Secondary Markets for U.S. Treasury Secutities $7 ‘The Primary and Secondary Market for Corporate Bonds 58 Bond Prices, Yields to Maturity, and Bond Market Conventions 58 Compounding Conventions for Yields to Maturity 61 Settlement Dates 62 Accrued Interest 62 Yields to Maturity and Coupon Yields 62 Summary and Conclusions 64 3a 35 36 Appendix 2A "Accrued Interestand Yield to Maturity Conventions 67 2A.1 2A3 Accrued Interest and Coupons for Most U.S. Treasury Notes and Bonds: Actual/Actual 68 31 Coupons for US. Treasuries 69 Accrued Interest Computation for a Typical US, Treasury Security 69 Settlement Dates 69 Accrued Interest, Coupons, and Yields of U.S. Treasuries with Long and Short First Coupons 69 Example of How to Calculate ‘Accrued Interest and Coupons with Odd First Coupons 71 Yields to Maturity: Eifect of Long and Short First Coupon 72 38 Accrued Interest for Corporate Securities: 30/360 74 xvii Equity Financing 76 Types of Equity Securities 77 ‘Common Stock 77 Preferred Stock 78 Warrants 79 ‘Volume of Financing with Different Equity Instruments 79 Who Owns US. Equities? 80 ‘The Globalization of Equity Markets 80 Second Markets for Equity 81 ‘Types of Secondary Markets for Equity 81 Exchanges 82 Dealer Markets for Equity 82 International Secondary Markets for Equity 83 The Decision to Issue Shares Publicly 83 Demand- and Supply-Side Explanations for IPO Cycles 84 The Benefits of Going Public 86 The Costs of Going Public 86 The Process of Going Public 86 ated with [POs ty BB IPO Underpricing of US. Stocks 89 Estimate of International IPO Underpricing 89 What Explains Underpricing? 89 How Do I Get These Underpriced Shares? 90 The Incentives of Underwriters 91 ‘The Case Where Managers of the Issuing Firm Have Better Information Than Investors 91 The Case Where Some Investors Have Better Information Than Other Investors 92 The Case Where Investors Have Information that the Underwriter Does not Have 93 Long-Term Performance of IPOs 94 Implications for Market Efficiency 94xviii Contents . Portfolios of Two Perfectly ‘Saas ima Positively Correlated or Perfectly The Decision to Go Public Nesniely Come Revisited 95 ; : i The Feasible Means and Standard S91 [Summary and, Conclusieas! 196 Deviations from Portfolios of Other Pairs of Assets 131 .8 Interpreting the Covariance as a sty “8 ‘Marginal Variance 132 Valuing Financial Assets A Proof Using Derivatives from : . Calculus 132 ‘ Torin eis emneeats Numerical Interpretations of the iRortTolios Marginal Variance Result 133 4.1 Portfolio Weights 107 49 Finding the Minimum Variance The Two-Stock Portfolio 107 Portfolio 135 The Many-Stock Portfolio 109 4.10 Summary and Conclusions 138 42 Portfolio Returns 110 - . 4.3 Expected Portfolio Returns 111 5 Mean-Variance analysis aad * Portfolios of Two Stocks 111 Capital Asset Pricing Model Portfolios of Many Stocks 112 5.1 Applications of Mean-Variance 44 Variances and Standard Analysis and the CAPM in Use Deviations 112 Today 144 Return Varianees 113 Investment Applications of Mean- Estimating Variances: Statistical Variance Analysis and the Issues 114 CAPM 14 Standard Deviation 114 Corporate Applications of Mean- 45 Covariances and Correlations 115 Variance Analysis and the Covariance 115 CAPM 144 4.6 Variances of Portfolios and 5.2 The Essentials of Mean-Variance Covariances between Analysis 144 Portfolios 118 The Feasible Set 145 Variances for Two-Stock The Assumptions of Mean- Portfolios 118 Variance Analysis 146 Correlations, Diversification, and 5.3 The Efficient Frontier and Two-Fund Portfolio Variances 121 Separation 147 Portfolios of Many Stacks 122 ‘The Quest for the Holy Grail: A Simple Procedure for Computing Optimal Portfolios 147 Variances of Portfolios of Many ‘Two-Fund Separation 148 Stocks 123 54 The Tangency Portfolio and Optimal Covariances between Portfolio Investment 150 Returns and Stock Returns 126 Optimal Investment When a Risk- Finding the Covariance of the Free Asset Exists 150 Returns of Two Portfolios 126 Identification of the Tangency 4.7 The Mean-Standard Deviation Portfolio 152 Diagram 127 5.5 Finding the Efficient Frontier of Risky Combining a Risk-Free Asset with Assets 155 a Risky Asset in the Mean- 56 How Useful Is Mean-Variance Standard Deviation Analysis for Finding Efficient Diagram 128 Portfolios? 157Contents 5.1 The Relation between Risk and Expected Return 158 Relevant Risk and the Tangency Portfolio 158 Betas 159 Marginal Variance versus Total Variance 162 ‘Tracking Portfolios in Portfolio Management and as a'Theme for Valuation 164 58 The Capital Asset Pricing Model 166 Assumptions of the CAPM 166 The Conclusion of the CAPM 166 The Market Portfolio 167 Why the Market Portfolio Is the Tangency Portfolio 168 Implications for Optimal Investment 169 5.9 — Generalizing the Capital Asset Pricing. Model 169 What if Short Sales of Risky Assets Are Prohibited? 170 ‘The Market Portfolio's Mean- Standard Deviation Location with No Risk-Free Asset 170 Other Generalizations of the CAPM 172 5.10 Estimating Betas, Risk-Free Returns, Risk Premiums, and the Market Portfolio 173 Risk-Free or Zero-Beta Returns 173 Beta Estimation and Beta Shrinkage 173 Improving the Beta Estimated from Regression 174 Estimating the Market Risk Premium 176 Identifying the Market Portfolio 176 5.11 Empirical Tests of the Capital Assct Pricing Model 177 Can the CAPM Really Be ‘Tested? 177 Is the Value-Weighted Market Index Mean-Variance Efficient? 179 Cross-Sectional Tests of the CAPM 179 xix Times-Series Tests of the CAPM 182 Results of the Cross-Sectional and Time-Series Tests: Size, Market to Book, and Momentum 182 Interpreting the CAPM's Empirical Failures 185 5.12 Summary and Conclusions 187 Factor Models and the Arbitrage ing Theory 193 6.1 The Market Model: The First Factor Model 195 ‘The Market Model Regression 195 “The Market Model Variance Decomposition 196 Diversifiable Risk and Fallacious CAPM Intuition 198 Residual Correlation and Factor Models 198 62 The Principle of Diversification 199 Insurance Analogies to Factor Risk and Firm-Specific Risk 199 Quantifying the Diversification of Firm-Specific Risk 200 63 Multifector Models 201 ‘The Multifactor Model Equation 201 Interpreting Common Factors 201 64 — Estimating the Factors 202 Using Factor Analysis to Generate Factor Portfolios 202 Using Macroeconomic Variables to Generate Factors 203 Using Characteristic-Sorted Portfolios to Estimate the Factors 204 65 Factor Betas 205 ‘What Determines Factor Betas? 205 Foctor Models for Portfolios 205 66 Using Factor Models to Compute Covariances and Variances 206 ‘Computing Covariances in a One- Factor Made) 207 ‘Computing Covariances from in a Multifactorxx Coments Factor Models and Correlations between Stock Returns 208 Applications of Factor Models to Mean-Variance Analysis 209 Using Factor Models to Compute Variances 209 6.7 Factor Models and Tracking Portfolios 210 Tracking Portfolios and Corporate Hedging 211 Capital Allocation Decisions of Corporations and Tracking Portfolios 211 Designing Tracking Portfolios 212 6.8 Pure Factor Portfolios 214 Constructing Pure Factor Portfolios from More Primitive Securities 214 The Risk Premiums of Pure Factor Portfolios 215 69 Tracking and Arbitrage 216 Using Pure Factor Portfolios to Track the Returns of a Security 216 ‘The Expected Return of the Tracking Portfolio 217 Decomposing Pure Factor Portfolios into Weights on More Primitive Securities 217 6.10 No Arbitrage and Pricing: The Arbitrage Pricing Theory 218 The Assumptions of the Arbitrage Pricing Theory 218 Arbitrage Pricing Theory with No Firm-Specific Risk 218 Graphing the APT Risk Return Equation 219 Verifying the Existence of Arbitrage 221 The Risk-Expected Return Relations for Securities with Firm-Spccific Risk 222 6.11 Estimating Factor-Risk Premiums and Factor Betas 225 6.12 Empirical Tests of the Arbitrage Pricing Theory 225 Empirical Implications of the APT 226 Evidence from Factor Analysis Studies 226 Evidence from Studies with Macrocconomic Factors 226 Evidence from Studies that Use Firm Characteristics 227 6.13 Summary and Conclusions 228 Pricing Derivatives 234 7.1 Examples of Derivatives 236 Forwards and Futures 236 Swaps 240 Options 243 Real Assets 248 Mortgage-Backed Securities 248 Structured Notes 249 7.2. The Basics of Derivatives Pricing 249 Perfect Tracking Portfolios 249 No Arbitrage and Valuation 250 the Basic Principles of ives Valuation to Value Forwards 250 7.3. Binomial Pricing Models 253 Tracking and Valuation: Static versus Dynamic Strategies 253 Binomial Model Tracking of a Structured Bond 254 Using Tracking Portfolios to Value Derivatives 255 Risk-Neutral Valuation of Derivatives: The Wall Street Approach 258 7.4 Multiperiod Binomial Valuation 263 How Restrictive Is the Binomial Process in a Multiperiod Setting? 264 Numerical Example of Multiperiod Binomial Valuation 264 Algebraic Representation of Two- Period Binomial Valuation 265 7.5 Valuation Techniques in the Financial Services Industry 266 Numerical Methods 266 The Risk-Free Rate Used by Wall Street Firms 268 7.6 Summary and Conclusions 268 Options 274 8.1 A Description of Options and Option Markets 27582 83 84 85 86 87 88 89 Contents European and American Options 275 The Four Features of Options 276 Option Expiration 276 Put-Call Parity 278 Put-Call Parity and Forward Contracts: Deriving the Formula 279 Put-Call Parity and a Minimum Value for 2 Call 282 Put-Call Parity and the Pricing and Premature Exercise of American Calls 282 Put-Call Parity and Corporate Securities as Options 285 Put-Call Parity and Portfolio Insurance 286 Binomial Valuation of European Options 288 Binomial Valuation of American Options 291 American Puts 292 ‘Valuing American Options on Dividend-Paying Stocks 294 Black-Scholes Valuation 295 Black-Scholes Formula 296 Dividends and the Black-Scholes Model 296 Estimating Volatility 296 Using Historical Data 298 The Implied Volatility Approach 299 Black-Scholes Price Sensitivity to Stock Price, Volatility, Interest Rates, and Expiration Time 300 Delta: The Sensitivity to Stock Price Changes 300 Black-Scholes Option Values and ‘Stock Volatility 301 Option Values and Time to Option Expiration 302 Option Values and the Risk-Free Interest Rate 303 A Summary of the Effects of the Parameter Changes 303 1g Options on More Complex Assets 304 ‘The Forward Price Version of the Black-Scholes Model 304 Val 8.10 8.ll Pant II xxi (Computing Forward Prices from Spot Prices 304 Applications of the Forward Price Version of the Black-Scholes Formula 305 American Options 306 ‘American Call and Put Currency Options 307 Empirical Biases in the Black-Scholes Formula 307 ‘Summary and Conclusions 308 Valuing Real Assets 9 Investing in Risk-Free Projects 318 9.1 92 93 94 95 Cash Flows 320 How to Compute Incremental Cash Flows 320 Real Asset Cash Flows and Fina ‘ash Flows 321 Net Present Value 321 Discounted Cash Flow and Net Present Value 322 Project Evaluation with the Net Present Value Rule 323 Present Values and Net Present Values Have the Value Additivity Property 326 Using NPV with Capital Constraints 328 Using NPV 10 Evaluate Projects That Can Be Repeated over Time 329 Economic Value Added (EVA) 330 Using NPV for Other Corporate Decisions 333 Evaluating Real Investments with the Internal Rate of Return 334 Intuition for the IRR Method 334 ‘Numerical Heration of the IRR 335 NPV and Examples of IRR 335 ‘Term Structure Issues 339 Cash Flow Sign Patterns and the ‘Number of Internal Rates of Return 340 Sign Reversals and Multiple Internal Rates of Return 345 Mutually Exclusive Projects and the Internal Rate of Return 345Coments 9.6 Popular but Incorrect Procedures for Evaluating Real Investments 348 The Payback Method 348 The Accounting Rate of Return Criterion 348 9.7 Summary and Conclusions 349 Appendix 9A. The Term Structure of Interest Rates 352 9A.1 Term Structure Varieties 353 Uses of Spot Yiclds and Where They Come From 353 Forces Driving the Term Structure of Interest Rates 353 9A.2 — SpotRates, Annuity Rates, and Par S354 Using Spot Yields to Compute Annuity Yields and Par Yields 354 ‘Computing Spot Yields from Par Yields and Annuity Yields 356 Why Spot Yields Should Be Computed from Par Yields 358 10 Investing in Risky Projects 360 10.1 ‘Asset Pricing Models and the Tracking Portfolio Approach 363 Implementing the Tracking Portfolio Approach 364 Linking Financial Asset Tracking to Real Asset Valuation with the SML 365 102 — The Risk-Adjusted Discount Rate Method 366 Defining and Implementing the Risk-Adjusted Discount Rate Method with Given Betas 366 The Tracking Portfolio Method Is Implicit in the Risk-Adjusted Discount Rate Method 367 10.3 The Effect of Leverage on Comparisons 368 ‘The Balance Sheet for un All Equity-Financed Firm 368 The Balance Sheet for a Firm Partially Financed with Debt 368 10.4 10.5 10.6 10.7 ‘The Right-Hand Side of the Balance Sheet as a Portfolio 36g Graphs and Numerical Illustrations of the Effect of Debt on Risk 370 Implementing the Risk-Adjusted Discount Rate Formula with Comparison Firms 372 The CAPM, the Comparison Method, and Adjusting for Leverage 372 Obtaining a Cost of Capital from the Arbitrage Pricing Theory (APT) 373 Costs of Capital Computed with Alternatives to CAPM and APT: Di nd Discount Models 375 What if No Pure Comparison Firm Exists? 378 Pitfalls in Using the Comparison Method 379 Project Betas Are Not the Same as Firm Betas 379 Growth Opportunities Are Usually the Source of High Betas 379 Multiperiod Risk-Adjusted Discount Rates 380 Empirical Failures of the CAPM and APT 384 What if No Comparable Line of Business Exists? 384 Estimating Beta from Scenarios: The Certainty Equivalent Method’ 388 Defining the Certainty Equivalent Method 388 Identifying the Certainty Equivalent from Models of Risk and Return 389 The CAPM, Scenarios, and the Certainty Equivalent Method) 391 The APT and the Certainty Equivalent Method 392 The Relation between the Certainty Equivalent Formula and the Tracking Portfolio Approach 393 . Obtaining Certainty Equivalents with Risk-Free Scenarios 393Comenis A Description of the Risk-Free Scenario Method 393 Implementing the Risk-Free ‘Scenario Method in a Multiperiod Setting 396 Providing Certainty Equivalents without Knowing It 398, Computing Certainty Equivalents from Prices in Financial Markets 398 Forward Prices 399 ‘Tracking Portfolios that Contain Forward Contracts 399 10.9 Summary and Conclusions Appendix 10A Statistical Issues in Estimating the Cost of Capit! for the Risk-Adjusted Discount Rate Method 404 10A.1 108 399 Estimation Error and Denominator- Based Biases in Present Value Estimates 404 10A.2 Geometric versus Arithmetic Means and the Compounding-Based Bias 405 11 Allocating Capital and Corporate Strategy 408 Sources of Positive Net Present Value 410 Sources of Competitive ‘Advantage 410 Economies of Scope, Discounted Cash Flow, and Options 411 Option Pricing Theory as a Tool for Quantifying Economies of Scope 411 11.2 Valuing Strategic Options with the Derivatives Valuation Methodology 412 ‘Valuing a Mine with No Strategic, Options 412 ‘Valuing a Mine with an ‘Abandonment Option 415 Valuing Vacant Land 418 ‘Valuing the Option to Delay the Start of a Manufacturing Project 421 ‘Valuing the Option to Expand Capacity 424 12 xxiii ‘Valuing Flexibility in Production ‘Technology: The Advantage of Being Different 426 ‘The Ratio Comparison Approach 429 ‘The Price/Earnings Ratio Method 430 ‘When Comparison Investments Are Hidden in Multibusiness Firms 430 The Effect of Earnings Growth and Accounting Methodology on Price/Earnings Ratios 432 The Effect of Leverage on Price Earnings Ratios 432 Adjusting for Leverage Differences 436 ‘The Competitive Analysis Approach 437 Relating a Division's Contributions toFirm Value 437 Disadvantages of the Competitive Analysis Approach 437 When to Use the Different Approaches 438 Can the Approach Be Used at AI? 438 Valuing Asset Classes versus Specific Assets 438 ‘Tracking Error Considerations 438 Other Considerations Summary and Conclusions 3 14 1s 439 116 439 Corporate Taxes and the Impact of Financing on Real Asset Valuation 445 12.1 Corporate ‘Taxes and the Evaluation of Equity-Financed Capital Expenditures 447 After-Tax Real Asset Cash Flows 448 ‘The Cost of Capital 451 The Risk of the Components of the Firm’ Balance Sheet with Tax- Deductible Debt Interest 452 Identifying the Unlevered Cost of Capital 454 ‘The Adjusted Present Value Method 455 12.2xxi Coments Three Sources of Value Creation for Shareholders 456 Debt Capacity 457 The APV Method Is Versatile and Usable with Many Valuation ‘Techniques 458 12.3. The Weighted Average Cost of Capital 464 Valuing a Business with the WACC Method When a Debt Tax Shield Exists 464 WACC Components: The Cost of Equity Financing 465 WACC Components: The Cost of Debt Financing 465 Determining the Costs of Debt and Equity from Expected Rates of Return at Project Adoption Time 468 The Effect of Leverage on a Firm's WACC When There Are No Taxes 468 The Effect of Leverage on a Firm's WACC with a Debt Interest Corporate Tax Deduction 470 Evaluating Individual Projects with the WACC Method 473 12.4 Discounting Cash Flows to Equity Holders 476 Positive NPV Projects Can Reduce Share Prices When Transfers to Debt Holders Occur 476 Computing Cash Flow to Equity Holders 477 Valuing Cash Flow to Equity Holders 478 Derivatives Valuation versus the Risk-Adjusted Discount Rate Method 479 12S Summary and Conclusions 479 Partly Capital Structure 13 How Taxes Affect Financing Choices 488 13.1 The Modigliani-Miller Theorem 489 13.2 13.3 13.4 13.5 13,6 13.7 13.8 13.9 13.10 Slicing the Cash Flows at the Firm 489 Proof of the Modigliani-Miller Theorem 490 Assumptions of the Modigliani. Miller Theorem 492 How an Individual Investor Can “Undo” a Firm’s Capital Structure Choice 493 How Risky Debt Affects the Modigliani-Miller Theorem 494 The Modigliani-Miller Theorem with Costless Bankruptcy 494 Leverage Increases and Wealth Transfers 495 How Corporate Taxes Affect the Capital Structure Choice 496 How Debt Affects After-Tax Cash Flows 497 How Debt Affects the Value of the Firm 497 How Personal Taxes Affect Capital Structure 499 Relevant Features of the U.S. Tax Code 499 The Effect of Personal Taxes on Debt and Equity Rates of Return 500 How Personal Taxes Affect the Capital Structure Choice: The Miller Equilibrium 503 Capital Structure Choices When Taxable Earnings Are Low 505 Taxes and Preferred Stock 507 Taxes and Municipal Bonds 508 The Effect of Inflation on the Tax Gain from Leverage 509 Are There Tax Advantages to Leasing? 510 Operating Leases and Capital Leases S11 The After-Tax Costs of Leasing and Buying Capital Assets 51] The Empirical Implications of the Analysis of Debt and Taxes 513 Do Firms with More Taxable Earnings Use More Debt Financing? 51314 Contents How the Tax Reform Act of 1986 Affected Capital Structure Choice 513 Summary and Conclusions 514 Sel. 13.11 How Taxes Affect Dividends and Share Repurchases 517 14.1 15.2 How Much of U.S. Corporate Earnings Is Distributed to Shareholders? 519 Have Dividend Payout Ratios Changed over Time? 519 Ageregate Share Repurchases and Dividends 519 Dividend Policies of Selected US. Firms 520 14.2 Distribution Policy in Frictionless Markets 521 The Accounting Identity for Sources and Uses of Corporate Cash Flow 521 The Miller-Modigliani Dividend Irrelevancy Theorem 522 Optimal Payout Policy in the Absence of Taxes and Transaction Costs 525 ‘The Effect of Taxes and Transaction Costs on Distribution Policy 526 ‘A Comparison of the Classical and Imputation Tax Systems $26 How Taxes Affect Dividend Policy 527 Dividend Clienteles 528 Why Do Corporations Pay Out So Much in Taxed Dividends? 529 How Dividend Policy Affects Expected Stock Returns 530 Ex-Dividend Stock Price Movements 530 ‘The Cross-Sectional Relation between Dividend Yields and Stock Returns 532 How Dividend Taxes Affect Financing and Investment Choices 534 Dividends, Taxes, and Financing Choices 534 Dividends, Taxes, and Investment Distortions 535 Summary and Conclusions 538 153 143 4 144 155 14.5 14.6 15.6 xxv, 15 Bankruptcy Costs and Debt Holder— Equity Holder Conflict 542 Bankruptcy 544 The US, Bankruptcy Code The Direct Costs of Bankruptcy 545 Debt Holder-Equity Holder Conflicts: ‘An Indirect Bankruptey Cost 546 Equity Holder Incentives 547 The Debt Overhang Problem The Shortsighted Investment Problem 552 The Asset Substitution Problem 553 ‘The Incentives of a Firm to Take Higher Risks: The Case of Unistar 554 How Do Lenders Respond to Shareholder Incentives? 555 ‘The Reluctance to Liquidate Problem 560 How Chapter 11 Bankruptcy Mitigates Debt Holder—Equity Holder Incentive Problems 564 How Can Firms Minimize Debt Holder-Equity Holder Problems? 565 Protective Covenants 565 Bank and Privately Placed Debi 567 ‘The Use of Short-Term versus Long-Term Debt 568 Security Design: The Use of Convertibles 569 Management Compensation Contracts 569 al Implications for Financing Choices $70 How Investment Opportunities Influence Financing Choices 570 inancing Choices Influence 544 548 Em iment Cl 570 Firm Size and Financing Choices $71 Evidence trom Japan $71 Summary and Conclusions 572xxvi Conients 16 Capital Structure and Corporate Strategy 577 16.1 The Stakeholder Theory of Capital Structure 579 Nonfinancial Stakeholders 579 How the Costs Imposed on Stakeholders Affect the Capital Structure Choice 580 Financial Distress and the Credibility of Implicit Claims 582 Whom Would You Rather Work For? 584 Summary of the Stakeholder Theory $88 16.2. The Benefits of Financial Distress with Committed Stakeholders 586 Bargaining with Unions 586 Bargaining with the Government 587 16.3 Capital Structure and Competitive Strategy 588 Does Debt Make Firms More or Less Aggressive Competitors? 588 Debt and Predation 590 Empirical Studies of the Relationship between Debt Financing and Market Share $90 16.4 Dynamic Capital Structure Considerations 591 ‘The Pecking Order of Financing Choices 592 ‘An Explanation Based on ‘Management Incentives 593 ‘An Explanation Based on Managers More Information than Investors ‘An Explanation Based on the Stakeholder Theory 593 An Explanation Based on Debt Holder-Equity Holder Conflicts 593 16.5 Empirical Evidence on the Cupital Structure Choice 595 16.6 Summary and Conclusions 597 Part V ParrV Incentives, Information, and Corporate Control 47 How Managerial Incentives Affect Financial Decisions 605 17.1 The Separation of Ownership and Control 607 Whom Do Managers Represent? 607 What Factors Influence Managerial Incentives? 607 How Management Incentive Problems Hurt Shareholder Value 608 Why Shareholders Cannot Control Managers 608 Changes in Corporate Governance 610 17.2. Management Shareholdings and Market Value 611 The Effect of Management Shareholdings on Stock Prices 611 Management Shareholdings and Firm Value: The Empirical Evidence 612 17.3 How Management Control Distorts Investment Decisions 613 ‘The Investment Choices Managers Prefer 613 Outside Shareholders and Managerial Discretion 615 17.4 Capital Structure and Managerial Control 615 The Relation between Shareholder Control and Leverage 616 How Leverage Affects the Level of Investment 616 ‘A Monitoring Role for Banks 619 17.5 Executive Compensation 619 The Agency Problem 620 Is Executive Pay Closely Tied t0 Performance? 621 How Does Firm Value Relate to the Use of Perfarmance-Based Pay? 623 Is Executive Compensation Tied © Relative Performance? 624Contens Stock-Based versus Earnings-Based Performance Pay 625 Compensation Issues, Mergers, and. Spin-Offs 626 17.6 Summary and Conclusions 627 18 The Information Conveyed by Financial Decisions 632 18.1 Management Incentives When Managers Have Beuicr Information Than Shareholders 634 Conflicts between Short-Term and Long-Term Share Price Maximization 634 18.2. Earnings Manipulation 636 Incentives to Increase or Decrease Accounting Earnings 637 18.3 Shortsighted Investment Choices 637 ‘Management’s Reluctance to Undertake Long-Term Investments 637 What Determines a Manager's Incentive to Be Shortsighted? 639 184 The Information Content of Dividend and Share Repurchase Announcements 639 Empirical Evidence on Stock Returns at the Time of Dividend Announcements 639 ‘A Dividend Signaling Model 640 Dividend Policy and Investment Incentives 643 Dividends Attract Attention 646 The Information Content of the Debt- Equity Choice 646 A Signaling Model Based on the Tax Gain/Financial Distress Cost Trade-Off 646 ‘Adverse Selection Theory 649 18.6 Empirical Evidence 653 ‘What Is an Event Study? 653 Event Study Evidence 655 How Does the Availability of Cash Affect Investinent Expenditures? 659 18.7 Summary and Conclusions 660 18.5 19 xvii Mergers and Acquisitions 666 19.1 A History of Mergers and Acquisitions 667 ‘Types of Mergers and jons 669 192 669 Financial Acquisitions 670 Conglomerate Acquisitions 670 Summary of Mergers and Acquisitions 671 Sources of Takeover Gains 671 Tax Motivations 672 Operating Synergies 673, Management Incentive Issues and Takeovers 674 Financial Synergies 677 Is an Acquisition Required to Realize Tax Gains, Operating Synergies, Incentive Gains, or Diversification? 678 advantages of Mergers and Acquisitions | 679 Conglomerates Can Misallocate Capital 679 Mergers Can Reduce the Information Contained in Stock Prices 679 A Summary of the Gains and Costs of Diversification 680 Empirical Evidence on Takeover Gains for Non-LBO Takeovers 680 Stock Returns around the Time of Takeover Announcements 681 Empirical Evidence on the Gains to Diversification 683 Accounting Studies 684 19.6 Empirical Evidence on the Gains from Leveraged Buyouts (LROs) 685 How Leveraged Buyouts Affect Stock Prices 685 Cash Flow Changes Follo\ Leveraged Buyouts 685 Valuing Acquisitions 687 Valuing Synergies 688 A Guide to the Valuation of Synergies 688 19.8 Financing Acquisitions 692 193, 194 The 19.5 1B 197xviii Contents ‘Tax Implications of the Financing of a Merger or an Acquisition 692 Accounting Implications of the Financing of a Merger or an Acquisition 693 Capital Structure Implications in the Financing of a Merger or an Acquisition 694 Information Effects from the Financing of a Merger or an Acquisition 694 19.9 Bidding Strategies in Hostile Takeovers 695 ‘The Free-Rider Problem 695 Solutions to the Free-Rider Problem 696 19.10 Management Defenses 699 Greenmail 699 Staggered Boards and Supermajority Rules 700 Poison Pills 701 Antitakeover Laws 701 Are Takeover Defenses Good for Shareholders? 701 19.11 Summary and Conclusions 701 Part VI Risk Management 20 Risk Management and Corporate Strategy 711 20.1 Risk Management and the Modigliani-Miller Theorem 712 The Investor's Hedging Choice 712 Implications of the Modigliani- Miller Theorem for Hedging 713 Relaxing the Modigliani-Miller Assumptions 713, 20.2 Why Do Firms Hedge? 714 A Simple Analogy 715 How Does Hedging Increase Expected Cash Flows? 715 How Hedging Reduces Taxes 716 20.3 204 20.5 20.6 20.7 20.8 20.9 Hedging to Avoid Financial Distress Costs. 717 Hedging to Help Firms Plan for Their Capital Needs 719 How Hedging Improves Executive Compensation Contracts and Performance Evaluation 721 How Hedging Improves Decision Making 723 The Motivation to Hedge Affects What IsHedged 724 How Should Companies Organize Their Hedging Activities? 725 Do Risk Management Departments Always Hedge? 726 How Hedging Affects the Firm's Stakeholders 727 How Hedging Affects Debt Holders and Equity Holders 727 How Hedging Affects Employees and Customers 727 Hedging and Managerial Incentives 727 ‘The Motivation to Manage Interest Rate Risk 728 Alternative Liability Streams 729 How Do Corporations Choose between Different Liability Streams? 730 Foreign Exchange Risk Management 732 ‘Types of Foreign Exchange Risk 732 Why Do Exchange Rates Change? 734 Why Most Firms Do Not Hedge Economic Risk 737 Which Firms Hedge? The Empirical Evidence 738 Latger Firms Are More Likely 0 Use Derivatives than Smaller Firms 738 Firms with More Growth Opportunities Are More Likely to Use Derivatives 739 Highly Levered Firms Are More Likely to Use Derivatives 739Contents Risk Management Practices in the Gold Mining Industry 739 20.10 Summary and Conclusions 740 21 The Practice of Hedging 743 21.1 Measuring Risk Exposure 744 Using Regression to Estimate the Risk Exposure 745 Measuring Risk Exposure with Simulations 745 Prespecification of Factor Betas from Theoretical Relations 746 Volatility as a Measure of Risk Exposure 746 Value at Risk as a Measure of Risk Exposure 747 21,2. Hedging Short-Term Commitments with Maturity-Matched Forward Contracts 749 Review of Forward Contracts How Forward-Date Obligations Create Risk 749 Using Forwards to Eliminate the Oil Price Risk of Forward Obligations 749 Using Forward Contracts to Hedge Currency Obligations 751 Hedging Short-Term Commitments ‘with Maturity-Matched Futures Contracts 753 Review of Futures Contracts, ‘Marking to Market, and Futures Prices 753 Tuiting the Futures Hedge 21.4 Hedging and Convenience Yields 756 When Convenience Yields Do Not Affect Hedge Ratios 756 How Supply and Demand for Convenience Determine Convenience Yields 756 Hedging the Risk from Holding Spot Positions in Commodities with Convenience Yields 757 21,5 Hedging Long-Dated Commitments ‘with Short-Maturing Futures or Forward Contracts 758 Maturity, Risk, and Hedging in the Presence of a Constant Convenience Yield 759 749 213 753 xxix Quantitative Estimates of the Oil Futures Stack Hedge Error 761 Intuition for Hedging with a Maturity Mismatch in the Presence of a Constant Convenience Yield 762 Convenience Yield Risk Generated by Correlation between Spot Prices and Convenience Yields 763 Basis Risk 764 Hedging with Swaps 765 Review of Swaps 765 Hedging with Interest Rate Swaps 766 Hedging with Currency Swaps 767 Hedging with Options 769 Why Option Hedging ts Desirable 769 Covered Option Hedgin Floors 770 Delta Hedging with Options 773 Factor-Based Hedging 774 Computing Factor Betas for Cash Flow Combinations 74 Computing Hedge Ratios 775 Direct Hedge Ratio Computations: Solving Systems of Equations 776 Hedging with Regression 777 Hedging a Cash Flow with a Financial Instrument 777 Hedging with Multiple Regression 778 21,10 Minimum Variance Portfolios Mean-Variance Analysis 779 Hedging to Arrive at the Minimum Variance Portfolio 779. Hedging to Arrive at the Tangency Portfolio 781 Summary and Conclusions 782 21.6 217 : Caps and 21.8 219 gle 20.1 Interest Rate Risk Management 787 22.1 The Dollar Value of a One Basis Point Decrease (DVO1) 789 Methods Used to Compute DVOL for Traded Bonds 789Ax Comens Using DVO1 to Estimate Price Changes 791 DVOIs of Various Bond Types and Portfolios 791 Using DVO1s to Hedge Interest Rate Risk 791 How Compounding Frequency Affects the Stated DVOL 793 Duration 795 The Duration of Zero-Coupon Bonds 795 The Duration of Coupon Bonds 795 Durations of Discount and Premium-Coupon Bonds 796 How Duration Changes as Time Elapses 796 Durations of Bond Portfolios 796 How Duration Changes as Interest Rates Increase 798 22.3. Linking Duration to DVOL 799 Duration asa Derivative 799 Formulas Relating Duration to DVol 800 Hedging with DVO1s or Durations 801 22.4 Immunization 802 Ordinary Immunization 803 Immunization Using DVOL 806 Practical Issues to Consider 806 Contingent Immunization 807 Immunization and Large Changes in Interest Rates 807 22.5 Convexity 807 Defining and Interpreting Convexity 808 Estimating Price Sensitivity to Yield 809 Misuse of Convexity 810 Interest Rate Hedging When the Term Structure Is Not Flat 814 The Yield-Beta Solution 814 The Parallel Term Structure Shift Solution: Term Structure DVO1 816 22.6 MacAuley Duration and Present Value Duration 816 Present Value Duration as a Derivative 818 22.7 Summary and Conclusions 818 Appendix A Interest Rate Mathematics 824 A.1 Cash Flows from Long and Short Positions 824 Cash Flow Sign Conventions 824 Short Sales 824 Value versus Cash Flow Arbitrage 825 Interest Rates and Rates of Return ina One-Period Setting 825 Defining a Rate of Return Over a Period 825 The Fallacy of Causation 825 Riskless Bonds: Yield versus Price 825 Rates of Return in a Multiperiod Setting 825 Generalizing the Present Value and Future Value Formulas 826 Explicit versus Implicit Interest 826 Value Additivity and Present Values of Cash Flow Streams 827 Annuities and Perpetuities 827 Perpetuities 828 Annuities 829 Growing Perpetuit Growing Annuities Simple Interest 831 ‘Time Horizons and Compounding Frequencies 831 Annualized Rates 832 Equivalent Rates 832 A8& Summary and Conclusions 833 824 A2 A3 A4 AS =s 830 831 AG AT Appendix Mathematical Tables 837 Index 847